Question

Crude oil is a key input into the production of many goods and services. When some political events reduce the supply of crude oil flowing from the Middle East, the price of oil rises around the world. U.S. firms that produce gasoline, tires, and many other products experience rising costs, and they find it less profitable to supply their output of goods and services at any given price level.

Q: Explain the short-run and long-run impacts of oil price increase on output and price level in the U.S. using the model of aggregate demand and aggregate supply.

Answer 1

In the short run as the price of crude-oil rises, the cost of production becomes higher for many of the prodducers, so they cut down their production. This is a reduction in the supply and it results a leftward shift in the supply curve as shown in the above graph from S1 to S2. The leftward supply curve results in a higer price level in the economy and a reduced quantity demanded. The price level rises from P1 to P2 and the quantity demanded reduce to Q1 to Q2.

In the long run the aggreagte supply curve is a vertical staright line, it is because the real GDP and the potential GDP are equal. Here the potential GDP does not vary with the price level in the economy. Due to the increase in the rise in price of oil the quantity demanded may fall so it results in a lower price level in the economy and does not influence the output of the economy.